Participants in exchanges and other markets routinely buy, sell and otherwise deal in multi-laterally traded futures contracts. Such contracts may be standardized according to a contract type established by an exchange. A “long” or a “long counterparty” usually refers to a counterparty holding a long position in a futures contract. A long agrees to pay a contract price in return for the underlying commodity or asset at a predefined future date. A “short” or a “short counterparty” usually refers to a counterparty holding a short position in a futures contract. In some types of futures contracts, a short agrees to receive the final settlement price of the contract at the predefined future date in return for delivering the underlying commodity or asset. Other types of futures contracts may be brought to final settlement by cash settlement. The subject matter of the final settlement (e.g., what the short must provide to effect final settlement for contracts requiring delivery) is typically defined by the contract type and is the same for all contracts of that type. The contract price paid by the long is typically negotiated at the time the contract is entered.
For each multi-laterally traded futures contract, there is a long counterparty and a short counterparty. Generally, however, either the long or the short of each such contract is an exchange or clearinghouse. For example, a first counterparty may offer to sell a particular type of futures contract through an exchange. After the exchange publishes that offer, a second counterparty may purchase a futures contract of that type through the exchange at the offered price. The exchange then establishes a first contract in which the first counterparty is the short and the exchange clearinghouse is the long, and an offsetting second contract in which the second counterparty is the long and the exchange is the short, with the contract price of the first and second contracts (the accepted offer price of the first counterparty) being the same. The first and second counterparties do not know each other's identities.
As indicated above, some types of futures contracts are cash settled, i.e., there is a final mark-to-market of outstanding contracts subsequent to the last day of trading. Futures contracts may also require other types of payments. For example, a clearinghouse may require mark-to-market payments on a periodic basis or when the current value of a futures contract is less than a certain percentage of a party's margin account with the clearinghouse. These and other payments must typically be made in a currency that is specified by the futures contract. A market generally assumes that such payments will be unimpeded by illiquidity in a market for the specified currency, inconvertibility of the specified currency, non-transferability of the specified currency, or other scenarios in which the specified currency might not be readily available. Although exchange rates of various currencies relative to one another may fluctuate, conventional futures contracts typically contemplate an unrestricted availability of a specified currency on commercially reasonable terms. If adequate supplies of a specified currency are not available, it may be difficult to settle or otherwise make payments in connection with a futures contract.
As also indicated above, some types of futures contracts are “physically” settled, i.e., the short counterparty agrees to deliver the actual commodity at final settlement. In some cases, the short may do so by literally providing the contract amount of the quantity to a location specified by the contract (e.g., delivery of crude oil to an oil terminal, delivery of grain to a grain elevator). In other cases, the short may deliver the contracted—for commodity by providing documents (e.g., warehouse receipts representing commodities in storage) or other evidence establishing that the contracted—for amount of the quantity has been provided (e.g., data confirming transfer of a note, bond, stock or other financial instrument to a specified account). Some physical settlements can involve transfer of money. For example, a foreign currency futures contract could require transfer of a contract amount of a foreign currency (e.g., Euros, Yen, etc.) at final settlement in return for payment of the contract price in a different currency (e.g., U.S. Dollars).
In some cases, adequate supplies of a physical commodity may be unavailable, or physical delivery might otherwise by impractical for a large portion of short counterparties. Similarly, numerous long counterparties may have difficulty taking physical delivery. As but one example, a futures contract may call for delivery of 1,000 barrels of crude oil at one of several physical storage facilities that are owned and operated by private parties. Credit market concerns or other issues beyond the control of numerous counterparties may prevent those counterparties from making or taking delivery.
In the context of over-the-counter derivatives, forward contracts and other instruments traded and carried on a bilateral basis, parties have been known to reach various accommodations on a contract-by-contract basis. For example, two parties might agree that final settlement could be made in an alternative manner (e.g., paying an equivalent amount of a foreign currency or a cash value of a particular commodity) and/or deferred until a later date. However, there are qualitative and quantitative differences between bilaterally-traded derivatives and derivatives traded on a multi-lateral basis. Although it is often simple for two parties to work out an accommodation of an unforeseen contingency, futures contracts must account for the needs of a potentially large number of market participants.
As indicated above, futures contracts are typically standardized so as to facilitate selling, offsetting, and otherwise creating a functioning market for a contract of a particular type. At any one time there may be a large number of outstanding futures contracts of a particular type. Each of those contracts may have very similar terms (e.g., deliver a specified amount of a currency of other commodity on a specified date), but may involve different parties. Even if the parties to each individual contract could agree on an appropriate way to accommodate unforeseen conditions making physical settlement impractical, the accommodations would not be uniform across all of those contracts. This would be undesirable, as participants in futures contracts of a particular type should be treated fairly and consistently if a market for such contracts is to function properly.
In some cases, a commodity, futures or other type of exchange can take emergency action that modifies how all existing contracts of a particular type will be settled or otherwise performed. This is also undesirable. Such emergency actions invoke substantial governmental reporting requirements, can undercut market confidence, and can have other detrimental side effects.